How the violent gold collapse may pose a systemic risk to the financial system

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Let’s hope the violent collapse of gold prices in recent days remains a concern only for gold bugs betting big on the metal. But after seeing threads of contagion connect asset to asset in the crises of the last decade, we can’t help but wonder if the decline in gold prices could act as a catalyst in some unexpected corner of the markets.

What would be the financial transmission mechanism? If we were betting, we’d put our money on exchange-traded funds, or ETFs. These funds, which usually track some sort of index, are sort of like mutual funds, except they can be bought or sold on the spot, unlike traditional mutual funds. And they’ve been exploding in growth in recent years, topping over $1 trillion in assets.

Gold-based ETFs have seen some of the biggest growth. In fact, when gold prices were at their peak, a gold ETF—the SPDR Gold Trust (GLD)—briefly became the largest ETF in the world by assets, surpassing an ETF that tracks the S&P 500 stock index. But we wouldn’t be super concerned about ETFs like GLD. It’s a so-called “physical” ETF, which means the fund actually owns the underlying asset that it offers exposure to. There’s another kind of ETF, known as a “synthetic” ETF, which isn’t quite as straightforward.

Synthetic gold ETFs don’t actually own gold. They generate a return that mirrors the gold prices through a series of agreements— or bets—typically with some sort of bank. Here’s a look at how they work, from a Bank of England report that raised concerns about them.

Still there are risks. Last year, Bank of England analysts wrote:

Synthetic ETFs exhibit more of the characteristics that might contribute to the build-up of systemic risk. They are more complex than physical ETFs, although the degree of complexity remains far below that of some structured credit products developed in the run-up to the crisis. The derivative transactions between ETFs and affiliated banks (or those that the bank itself might undertake to gain exposure to the index) result in the build-up of counterparty credit exposures between market participants. And synthetic structures might pose funding liquidity risk to banks acting as swap counterparties if there is a sudden withdrawal of investors from the ETF market.

What might prompt such a withdrawal of investors from the ETF market? How about a gobsmacking 14% drop in the price of gold, which we’ve seen this month.

There’s an extremely good discussion of the risks of synthetic ETFs in this paper by the Bank for International Settlements. But the short version is that all of the risks get bigger when you see a large pronounced move to withdraw funds at once, such as the type that the current gold plunge risks setting off. So who might be exposed to losses from the gold selloff? It’s hard to say if there will even be any disruptions.

But synthetic ETFs are more popular and widely used in Europe than in the US. (Though physical ETFs have been gaining in popularity.)

So if we were looking for someone to take a hit, we’d be looking for European banks that act as parent entities for synthetic gold ETFs. Last year Morningstar churned out this helpful chart which laid out some of the entities behind the synthetic ETFs more broadly, which might be worth holding onto. Stay tuned.